The Rise of the Flexible Euro-AIF

A passport to success?

Originally published in the July | August 2016 issue

Times are changing for onshore European hedge funds. The structures that were traditionally trumpeted as being rivals to offshore funds – namely the Luxembourg specialised investment fund (SIF), Malta’s professional investor fund (PIF) and Ireland’s PLC/unit trust qualifying investor alternative investment fund (QIAIF) – but which had regulator driven and, at times, frustrating fund authorisation processes, are slowly giving way to easier to launch, flexible, less regulated structures, that look dramatically closer to their offshore domiciled cousins than ever before.

Last year saw the launch of the much publicised Irish ICAV, a new corporate QIAIF structure which involves a one day CBI authorisation process. 2016 has already seen Malta announce its own easier-to-launch hedge fund structure – the notified alternative investment fund (NAIF) – and, very shortly, Luxembourg, which has historically been viewed as a country with a lengthy launch process heavily involving the CSSF – will also introduce its own business friendly hedge fund – the reserved alternative investment fund (RAIF).

So whilst it’s out with the old and in with the new, is the 2015/2016 class of European hedge fund structures likely to pose a real challenge to Cayman’s pre-eminent position for hedge fund vehicles or instead are they likely to be short-lived fads?

Irish ICAV QIAIF: much needed but requires refinement
The Irish funds industry has done a superb job of selling the new ICAV QIAIF structure as a super-flexible, easy to use and fit for purpose product.

It certainly has significant benefits when compared with the old company PLC feeder/unit trust master fund structure. The new ICAV structure means that you can have a corporate feeder fund and corporate master fund. The corporate master fund can check the box for US tax purposes, avoiding the need for the clunky unit trust master fund under the old regime.

The fact that the unit trust structure – something which non-European allocators found unfamiliar – can now be dispensed with, means that optically, the Irish ICAV looks far more market standard and increases the prospect of raising US taxable, US tax-exempt and non-US capital within the same product. That said, non-European (including US) investors are not yet accustomed to investments in an ICAV structure and are approaching it with more caution. Unless US demand or familiarity with the product gets better then the very advantage that it offers (possibility of a better structure to attract both US taxable and non-US/US tax-exempt capital) will be a non-starter.

One other potential benefit of the ICAV is that it is automatically set up as an ‘umbrella’ entity. Despite misgivings from conservative investors, particularly US endowment schemes and pension plans, about whether or not the constitutional segregation of assets and liabilities from one sub-fund to another is free from risk, this at least offers the possibility of housing a number of different products within one structure and with that come efficiencies of scale and reduced overall launch costs.

The fact that an ICAV’s depositary can also approve non material amendments to the fund’s constitutional documents proposed by the fund’s board, without the need for a shareholder vote (the usual way to amend constitutional documents) underscores the potential user-friendliness of the ICAV structure, although it is yet to be seen, firstly, to what extent depositaries will be comfortable taking on the liability of signing off on these amendments and secondly, whether different depositary businesses will apply this principle consistently.

So how has the ICAV performed in its first year of operation? With 150 or so ICAVs launched, the headline statistics look promising. However, many of these are UCITS, rather than AIFs, and private equity fund launches make up a large number of the AIF launches. When you compare the headline figures to the 1000 plus Cayman fund launches in 2015, it is clear that Cayman still gets the gold medal by quite some distance.

Malta NAIF: surprise package?
In the wake of the more user-friendly Irish ICAV QIAIF and a new impending regime in Luxembourg, the Maltese regulator, the MFSA, has also launched a new type of AIF – adding yet further to the AIF acronyms. Malta announced the NAIF or “notified alternative investment fund” regime. The NAIF regime is currently expected to be available this summer.

The main advantage of the NAIF structure is that funds will be able to come to market without going through an authorisation process with the MFSA (as Maltese hedge fund structures currently must), but they will be able to make use of the AIFMD marketing passport at a time when the process in relation to the extension of the passport to Cayman and certain other offshore countries still lacks clarity.

Unlike the Irish ICAV QIAIF, the NAIF will not be MFSA-authorised or subject to itsongoing supervision. That said, the MFSA has committed to creating an official list of NAIFs in good standing on its website. Within 10 business days from the date of filing of a complete notification pack, the MFSA will include the NAIF in the official list. Therefore, there will be some residual form of regulatory oversight and whilst the process is not as fast as the Irish ICAV QIAIF, it should reduce the time to market for a Maltese hedge fund quite substantially.

The Maltese NAIF is definitely good news for those considering a hedge fund structure there – it will without question be significantly easier to launch a hedge fund using Malta, and in light of the developments in Ireland and Luxembourg, creation of this new regime seems like a shrewd move by the regulator.

One of the biggest challenges for the Maltese structure will be mass-market appeal. On paper it makes sense, the taxation regime is favourable, there is a growing service provider capability and the MFSA is widely viewed as being a business friendly regulator. The NAIF’s challenge however will be to make itself a mass market challenger, particularly for those with US allocators who may not be as familiar with Malta as a European jurisdiction, even when compared to Ireland and Luxembourg. Further, with the NAIF lacking the appeal of being a fund structure regulated by a European regulator, conservative European institutional investors may prefer the comfort of the existing regulated specialised investment fund (SIF) or at least the unregulated, but still ‘Luxembourgish’, RAIF.

Luxembourg RAIF: last to the finishing line but is it the winner?
In a very progressive move, Luxembourg will soon be unveiling a new alternative investment fund structure, which will provide alternative investment fund managers (AIFMs) authorised in any EEA member state with an efficient and potentially cost-effective fund vehicle with which to access the AIFMD marketing passport without having to suffer costs and delays associated with a further local regulatory overlay.

The legislative proposals still require the Luxembourg government’s approval but the new vehicle should be available in Q2 2016.

While based principally on Luxembourg’s current SIF regime, the new reserved alternative investment fund (RAIF) will not be subject to product level rules on eligibility of assets. This means that it should be possible to operate any fund strategy within the new vehicle – although there will still be diversification requirements.

Furthermore, in comparison to the Irish ICAV, the new vehicle will have the advantage of not requiring approval from the Luxembourg regulator, the Commission de Surveillance du Secteur Financier (CSSF), either at launch or on an ongoing basis. While some investors may perceive the lack of direct regulation by the CSSF as a disadvantage, indirect regulation by the AIFM’s home regulator is a logical response to the framework set up by AIFMD which requires regulation of the AIFM, rather than of the AIF itself.

It is expected that the RAIF regime will permit flexibility in terms of the legal form the vehicle may adopt, and so it should be possible for a RAIF to be established, for example, using the legal structure of a société en commandite par actions, or ‘SCA’. This a form of Luxembourg company which can ‘check the box’ to elect to be treated as a partnership for US tax purposes (in the same way an Irish ICAV master fund can) – an important feature for master-feeder hedge funds being sold to US taxable investors. Umbrella structures with multiple sub-funds should also be possible (although they need to be structured as so and aren’t automatically umbrella vehicles like the ICAV).

As the Luxembourg regulator finalises the rules relating to the RAIF, it would also do well to consider dispensing with the requirement to hold a mandatory AGM. This is a costlyoverhead for a fund and the ICAV QIAIF has provided optionality for the fund to dispense with the equivalent requirement in Ireland.

The lack of regulatory approval will mean that the time to market for managers will be much reduced with likely cost savings over other current types of fund vehicle. Most importantly, perhaps, the RAIF regime will present AIFMs in the UK and other EEA states with another unregulated, EU domiciled vehicle, allowing efficient access to the pan-European AIFMD marketing passport. It is early days to say whether or not the Luxembourg structure will become the onshore hedge fund structure of choice, but more conservative Continental investors could well be attracted to the mixture of a familiar and established jurisdiction, without the complexity of a CSSF process overlay.

Cayman: still in pole position?
If the AIFMD national private placement regimes were on track to be switched off by 2018 then a London manager targeting European investors would have no option but to consider the above structures in order to continue to raise capital.

However, despite the flexibility and business friendly nature of the above structures, Cayman and equivalent offshore funds are still able to be relatively easily marketed in markets considered to be key centres of capital and at present there is no visibility on when the private placement regimes will be switched off, if at all. If the process for the extension of the passport is anything to go by – delayed, slow and piecemeal – it could well be the end of the decade before any kind of switch off is considered.

Whilst the new flexible Euro-AIFs are definitely more attractive, whether or not they pose a real challenge to offshore funds in the medium term depends more on the actual cost of launch and the sentiment amongst allocators towards these new structures, not only in Europe, but in the US, Middle East and Asia as well.